The $7 Billion Delusion

Excite@Home promised to merge the search geeks and the cablecos to become the AOL of broadband. Then the tragedy of reality set in.

Some deals are hatched under a bad sign. Three years ago, Excite, the troubled yet promising Web portal, merged with @Home, the promising yet troubled high-speed Internet service provider. Hailed at the time by @Home's CEO as the "new media network for the 21st century," Excite@Home has ended up instead as digital roadkill, its assets picked over by bondholders and AT&T, its stock trading for pennies (down from a high of $99), its customers and creditors at the mercy of bankruptcy court.

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There are people who say it might have worked – that if this or that and five or six other things hadn't happened, Excite@Home would have become broadband's answer to America Online, delivering a fast, always-on Internet connection to millions upon millions of cable TV subscribers. But Excite on its own was losing out to Yahoo!, while @Home was the hapless ward of fractious cable chieftains. Put them together? "I personally think this was, in the history of mergers, one of the most idiotic ever conceived by two independent, venture-backed boards," says Bart Schachter, a San Francisco venture capitalist who once represented Intel Capital on the board of @Home. Leo Hindery, the longtime cable magnate who also sat on the @Home board, is even blunter: "AOL and Yahoo! were already in the lead, and there was no room for a number three portal. That was the absurdity of the deal – it was the $7 billion delusion."

Both singly and in combination, Excite and @Home were the pure product of the Silicon Valley mentality: Match some computer geeks with a business plan, fuel them to the gills with venture capital, and let 'er rip. People snickered when Walt Disney bought a rival portal that fell to earth, but the Excite@Home saga suggests that some of the sharpest minds in the Valley were equally at sea when it came to building an online media enterprise. In part, it was a culture clash – the Web people didn't understand the broadband world, the broadband people didn't understand Web content, and neither of them cared squat about cable. There were countless missteps, but the fatal flaw was hubris: the blithe assumption that you could construct an Internet-based media giant on top of the cable industry without ever learning how that industry worked.

The current tech bust has claimed no end of victims, from me-too dotcoms to strung-out fiber providers, but the boldness of Excite@Home's vision – to create a media powerhouse for the broadband future – makes it a special case. Like other prospectors in the Internet gold rush, the people running Excite and @Home were all too aware that they could perish at any moment. The irony is that, more than any other company, this one actually was delivering on the miragelike promise of high-speed Internet access. So what went wrong? "Business schools will love this," says one survivor.

Clearly, each half of Excite@Home had its problems from the start. Excite was conceived in 1993, when six pals from Stanford began looking for an idea that would keep them from having to get jobs. Graham Spencer, the tech whiz in the group, set out to build a software tool for searching large databases; he finished just as the world was discovering the largest, most out-of-control database of all: the Internet. But it didn't occur to Spencer and his friends to turn their search engine into a Web business until they connected with Vinod Khosla of Kleiner Perkins Caufield & Byers, the legendary venture firm behind such giants as Sun Microsystems. In addition to helping out with financing and strategy, Khosla encouraged the Excite crew to think big – "to believe in the size of the opportunity," says Joe Kraus, one of the founders, "and build up the company to meet it."

By 1997, two years after Kleiner Perkins signed on, Excite had emerged from the pack of early search engines and Web directories to become a strong number two behind Yahoo! Both sites were morphing into portals, adding every online feature they could think of, from address books to stock portfolios. The idea was no longer to send users out to the Web but to keep them captive in order to draw advertisers. But while Yahoo! relied on heavy marketing to stay ahead, Excite pursued an all-out acquisition strategy. In 1998, it bought a Colorado company called MatchLogic that promised to transmute eyeballs into dollars – tracking users, targeting them demographically, delivering the kind of specifics to advertisers that print and broadcasting can only dream of. The MatchLogic people also contributed a slogan that captured Excite's way of thinking: "Go big or stay home." Gobosh, as it came to be known, was the rallying cry for the underdogs. As Excite CEO George Bell told Wired in September '98, "We drink a different kind of Kool-Aid."

Bell was a charismatic leader, an Emmy-winning television producer whose exploits shooting documentaries in the Amazon and the Himalayas gave him a certain Indiana Jones mystique. Making Excite a contender had been quite a feat, but it was becoming clear that there were too many portals for them all to survive. Consolidation was imperative. "It was a crazy year of musical chairs," says Khosla. "Basically, everybody was talking to everybody." Disney and NBC had just acquired smaller portals, and companies like Sony and Time Warner were looking as well. Excite didn't necessarily disdain the media giants, former executives maintain, but it also didn't see a marriage of portal and content as the ideal combo. Bell was growing suspicious of the everything-for-free motto of the Web. Paid subscriptions and services seemed more the way to go.

When AOL made a deal that fall to buy Netscape, the heat was on. By the beginning of 1999, Excite had two deals on the table and another that seemed close. Yahoo! made an all-stock offer, but like Excite, the company was entirely reliant on ad revenue. Worse, selling to Yahoo! would mean surrender – and for people who'd spent years scrambling desperately to get out of Yahoo!'s shadow, that was no good. Microsoft was interested in merging Excite with the Microsoft Network, which would put it in the paid access business; unfortunately, Microsoft president Steve Ballmer seemed in no hurry to make up his mind. That left @Home, the cable modem service, headquartered across the street in Redwood City.

That company had gotten its start in 1995, when two other Kleiner Perkins partners – John Doerr, the Valley's alpha VC, and Will Hearst, grandson of the newspaper magnate – cut a deal with Tele-Communications Inc., the cable outfit headed by John Malone. In exchange for a five-year exclusive, @Home would offer high-speed Internet access via cable modem to TCI customers. Since the Internet wasn't yet equipped to handle massive data transfers, Doerr and Hearst recruited a networking whiz, NASA's Milo Medin, who developed what was essentially a parallel Internet – long-haul fiber lines leased from AT&T and linked to regional data centers, where Web content could be stored for fast delivery. This looked like a good deal to Malone, and to Cox and Comcast and the other cable operators that later joined in. @Home provided them with the network capacity, the sales and marketing effort, and the billing and service operations needed to offer broadband, and gave them the bulk of the subscriber revenue as well. The cable companies still faced huge expenses in upgrading their lines to handle two-way data traffic – but at least with @Home they got holdings in a high-flying Internet stock.

It might have worked a lot better if they'd structured the partnership to benefit @Home and the cable operators equally. As it was, the cable guys were at odds because they each received equity in @Home in proportion to the total number of residences in their service area – even though TCI, which reached the most homes, had such low tech cable systems that most of those homes weren't ready for Internet access. Because the cable operators owned most of the company, the board was dominated by people whose first loyalty, arguably, was not to @Home but to their own employers. The cable operators and @Home had no incentive to work together on advertising, because all national ad revenue went to @Home while all local ad money went to the cable companies. And because no one paid enough attention to customer service, subscribers who phoned in with complaints got shuttled back and forth between the cable call centers, which were ill-equipped to deal with modem questions, and the @Home call center, which was ill-equipped to deal with customers.

The ultimate issue, however, was self-image. @Home viewed itself as a tech venture in the tradition of Intel, Apple, and Sun. "It was a classic Silicon Valley company – stock options, Porsches in the parking lot, the whole bit," says Bart Schachter, the board rep from Intel. "It was a startup that was going to kick butt." Yet to cable operators, it was a glorified subsidiary that couldn't even deliver on basic customer-satisfaction issues. "It could have been headquartered in Topeka, Kansas," says Leo Hindery. "It was fundamentally a distribution business and had little to do with Internet content."

Under the circumstances, @Home would have done well to address its own problems. But its CEO, Tom Jermoluk, figured that with Excite's help, he could develop video content to boost the wow factor and stimulate demand. He'd already negotiated a deal with Lycos, but Excite was his first choice. As for Excite, George Bell had just been forced to scrap plans to expand ecommerce and launch the first new marketing campaign in years, because only by slashing costs could he make good on his promise to show a profit by fall. By putting Excite's users together with @Home's subscribers (actually they were the cable companies' subscribers, but that technicality tended to be overlooked), they could create the AOL of broadband.

Hindery promised equal treatment for all content providers. Jermoluk, livid, blocked the deals. But the issue had already exploded.

Kleiner Perkins had VCs on both boards – Khosla on Excite's, and Doerr and Hearst on @Home's. They were in a better position than most to suspect that this pairing could turn out badly. Apparently, however, that thought never surfaced. "When broadband happened, we'd be in a position to be the dominant player – that was my thinking," says Khosla.

Though Kleiner Perkins had reduced its position considerably, the firm still had a significant stake in both companies, and Excite in particular had been shaky recently, its stock dropping from $55 to $18 before recovering to $42 at the end of 1998. A well-received merger agreement, with @Home paying a hefty premium to buy Excite, would allow Kleiner Perkins to distribute the remainder of its shares to its venture-fund investors while both stocks were riding high. Insiders say Kleiner played by the Silicon Valley rules. "There was zero, and I mean zero, pressure to do anything that was solely in Kleiner's interest," says Joe Kraus, the only cofounder on Excite's board. "It was, What's the best deal financially, and what looks like the best deal strategically?" So on January 19, 1999, @Home announced that it would acquire Excite for $6.7 billion in stock – the biggest Internet deal to date, and one that priced Excite at nearly double the stock market's valuation. That day, Kleiner Perkins hired a plane to fly over Redwood City with a banner in tow: CONGRATULATIONS T.J. & GEORGE.

There was one @Home board member who opposed the deal: Leo Hindery, the veteran cable guy who, with AT&T's acquisition of TCI in March 1999, became chief executive of AT&T Broadband, the venerable telco's new cable play. His objections were worth listening to, and Tom Jermoluk's failure to address them showed how out of touch with the cable business he really was. @Home faced a looming struggle with AOL over the issue of open access: whether cable systems, which enjoy a government-sanctioned monopoly in their local service areas, should be open to independent Internet service providers, just as local phone companies allow dialup access through any ISP. In Hindery's view, the question hinged on content. The rules governing cable and telecom were so different, you could argue that a cable company shouldn't have to open itself to competing ISPs. But giving preferential treatment to its own Web content struck Hindery as asking for trouble – and if the government started telling cable companies how to handle Web content, what was going to stop it from going further? "It was a political nightmare for the data business," he says, "and it opened up a Pandora's box for the traditional business."

Hindery was not shy about expressing his views, even after the merger was announced. The day before Excite shareholders were to ratify the deal, he declared at a telecom conference that AT&T intended to treat all Internet content providers equally. No sooner had the merger gone through than he started negotiating agreements with AOL, MSN, and Yahoo! that would give them, for a fee, the same treatment as Excite on his cable lines. Jermoluk was livid; backed by the rest of his board, he blocked the deals. But by this time, the access issue had already exploded.

The FCC didn't want to impose open access, because it was loath to set rules for the Internet. But AT&T's acquisition of TCI gave AOL the perfect forum. As the new owner, AT&T had to petition state and local authorities in all its service areas for a license transfer, and when regulators in Portland, Oregon, refused to grant the transfer without a guarantee of open access, AT&T had no choice but to sue them. This development came as a big shock to Excite. "We didn't really know a whole lot about @Home," admits Fred Siegel, then Excite's top marketing executive, who suddenly realized how serious the situation was when he contacted national PR firms and discovered they'd all been hired by AOL to work on its "grassroots" campaign in Portland. Ultimately AT&T prevailed in the courts. Still, Siegel adds, "We didn't know open access was going to be an issue. That took the Excite people and, I believe, some of @Home's people by surprise." So did lots of other things. "There was very little knowledge of the media business within @Home," says Ben Addoms, a MatchLogic cofounder who ran the media units after the merger, "and little to no knowledge of the cable business at Excite. There were a lot of false starts."

For a company that aspired to become the AOL of broadband, Excite@Home showed surprisingly little understanding of AOL. Unlike Excite, AOL was propelled by full-tilt marketing and a leader with an almost messianic belief in the experience of online community. And while AOL appealed to Middle Americans who weren't quite sure what the Internet was, @Home subscribers were tech sophisticates who weren't interested in being roped into an also-ran Web portal. Almost the only thing AOL and Excite@Home actually had in common was an aggressive growth strategy, but Excite@Home's was ill-fated.

In October 1999, only five months after the merger took effect, the company agreed to pay $780 million – $350 million of it in cash – for BlueMountain.com, a Colorado-based Web site that offered free electronic greeting cards. The site had virtually no revenue – it was supported by traditional greeting card sales from its parent company – but it did have more than 9 million visitors a month, most of them female. This hard-to-reach demographic was sure to appeal to advertisers and seemed a likely target for ecommerce offerings like flowers, chocolates, and CDs. "Greeting cards were merely a Trojan horse," says one former executive. "We thought it had real potential to be turned into an engine for revenue."

The VCs hit their limit when they tried to apply tech models to media. The root problem: hubris.

It might have – but time was running out. Far from solving Excite's and @Home's problems, the merger was amplifying them. Hindery resigned abruptly after a run-in with AT&T CEO Michael Armstrong, but that didn't make things any easier for Jermoluk. Armstrong and his telecom execs were an alien element in the fraternity of cable guys, and the friction that led to Hindery's departure spilled over into Excite@Home's boardroom. Even as the BlueMountain.com deal was being done, there were rumors that Excite@Home might be broken up. In the end, the board decided to spin off its media assets – Excite, MatchLogic, BlueMountain.com – as a separate tracking stock, in effect undoing the merger. But the tracking stock was never issued, just as the ecommerce plans for BlueMountain.com never materialized. By early 2000, the company was in free fall.

Advertising was dropping precipitously as failing ecommerce startups began to eliminate all their ad buys except AOL and Yahoo! The dwindling percentage of users who bothered to click on ads was calling into question the economic equation that portals were built on. Addoms and others argued that they should sell the media assets before it was too late, but Bell, who'd just succeeded Jermoluk as CEO, thought they were overly pessimistic. Yet soon after, Bell moved to Boston with his family and announced his intention to leave once a successor could be found. Other key figures – Kraus, Addoms, virtually the entire executive team – were on their way out as well. Says one who left, "Everything we tried was 'We could do this, but AT&T…' or 'We could do this, but Cox…' You're at home one night and you say to yourself, somehow it's just gotten too complicated."

The access business was starting to go haywire as well. Like many Internet startups, @Home had been lax about documenting its software code; as employees moved on, it became impossible to make changes or create new applications without months of work and constant crashes. Customer service was so lousy that subscribers were complaining to their cable providers. The Excite team disdained their @Home counterparts as boring engineers marching in lockstep with the cable operators, but the cable operators saw them as a loosey-goosey bunch who lacked the discipline to deliver a dependable service to their customers. "We had to stop the train and make major process changes," says a former executive. "It meant going from a Silicon Valley cowboy engineering environment to a space shuttle launch."

So AT&T stepped in to stabilize the network. Although the project was undertaken at Bell's instigation, the intrusive presence of telecom engineers and the amount of Excite@Home money they were throwing around on new equipment fed speculation on the Redwood City campus. Was it $40 million? $60 million? And was it really necessary to spend that kind of money to achieve network reliability at a time when the company's main source of revenue was drying up? (See "Tools of Self-Destruction.")

The bitterness many feel toward AT&T is hard to overstate. Nevertheless, the network expenditures were almost minor compared to the accelerating collapse of the media business. In January 2001, two years after the merger was announced, Excite@Home took a staggering $4.6 billion write-off on its media ventures. Three months later, the company posted a quarterly loss of nearly $850 million on revenue of less than $150 million, with only $100 million in cash left on hand. The same day, it introduced its new CEO: Patti Hart, a former Sprint exec who'd been president of Telocity, a provider of DSL, the technology that relies on ordinary copper phone lines. "Poor Patti," says one insider. "She didn't have a prayer."

Back in January 1996, as @Home was about to launch, Will Hearst predicted in Wired that it would have 1 million customers within a year. This proved embarrassing when a back-of-the-envelope calculation showed that even with every cable truck in America working 24 hours a day for the next 365 days, doing 1 million installations was simply not possible. In fact, it would be almost four years before @Home got its millionth customer – and yet, by the beginning of 2001, it would have nearly 3 million subscribers, a figure that has since grown to more than 3.7 million. Through the entire debacle, @Home has continued to add subscribers, proving the appeal of broadband and, with it, the ultimate viability of a next-stage Internet based not on pageviews, banner ads, and free content but on video email, movies-on-demand, and other offerings as yet unimagined. But none of this will benefit Excite@Home.

The wooded enclaves of Sand Hill Road, where Kleiner Perkins and a host of other venture capital firms nestle in the hills above Stanford, have given rise to enterprises that have transformed our world. But as business engineers, the VCs hit their limits when they tried to apply tech models to media. Excite@Home's strategic mistakes are myriad: too much faith in the portal concept and the potential of online advertising; too little understanding of AOL's appeal; failure to structure the cable modem business to the benefit of all concerned; failure to understand that @Home's real customers were not the subscribers but the cable operators that provided them; failure to see how the marriage of monopoly access with content could blow up in their faces. But the root problem was the hubris that led them to ignore, in a wireline business, whose wire they were riding in on.

The bankruptcy filing in September – coupled with announcements that the company would close MatchLogic, dump BlueMountain.com for just $35 million, sell @Home to AT&T for $307 million, and offload the Excite.com domain name to Infospace for $10 million – amounts to a crushing defeat for the employees who tried to make it work and the investors who rode the stock to the bottom. But the billions in vanished equity do not translate into a defeat for broadband – far from it. At minimal cost to themselves, the cable guys have managed to kickstart the deployment of broadband and gain a major new revenue source. And it hasn't been lost on them that Excite@Home is going the way of bankrupt DSL providers like NorthPoint and Covad, which were launched to exploit the phone lines of the local Bell companies. Cable or copper, it hardly matters: Whoever owns the line into the home is going to win. Anything else is wishful thinking.

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